Chapter 5 Actions and the Contract Assumption Defense

Posted on by Bob Bernstein

By Robert S. Bernstein, Esq.

Most, if not all, commercial bankruptcy practitioners have dealt with “avoidance actions,” suits to avoid and recover preferential, fraudulent, and unauthorized post-petition transfers. While the majority of defenses to these actions are prescribed by statute, the interplay between and Congressional intent behind various sections of the Bankruptcy Code have given rise to additional defenses to avoidance actions. One of these defenses is the Contract Assumption Defense, which can provide a perfect defense to avoidance actions. To understand the application of the Contract Assumption Defense, it is necessary to understand preferential, fraudulent, or unauthorized post-petition transfers of estate property, the policies underlying each cause of action, and the process, intent, and effect of the debtor’s assumption of an executory contract or unexpired lease.

I. Preferential, Fraudulent, and Unauthorized Post-Petition Transfers

The Bankruptcy Code authorizes trustees to avoid prepetition preferential and fraudulent transfers with the dual purpose of promoting equality of distribution among similarly situated creditors and reducing the incentive to dismember a financially-distressed debtor. Section 547(b) of the Bankruptcy Code allows a trustee to avoid any transfer of an interest in property of the debtor that was made: (i) to or for the benefit of the creditor; (ii) on account of an antecedent debt owed by the debtor before such transfer was made; (iii) while the debtor was insolvent; (iv) within 90 days before the filing of the bankruptcy petition; and (v) allowed such creditor to receive more than it would have received if the case were a case under chapter 7 of the Bankruptcy Code, the transfer had not been made, and the creditor received payment of such debt to the extent provided by the Bankruptcy Code. Section 547 also enumerates several exceptions (or defenses) to the trustee’s ability to avoid preferential transfers, such as transfers made in the ordinary course of business, transfers made as a contemporaneous exchange for new value, and transfers made where the creditor has provided subsequent new value to the estate after the transfer.

Section 548 of the Bankruptcy Code allows a trustee to avoid any fraudulent transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred within 2 years before the bankruptcy filing. The trustee can avoid any transfer made or obligation incurred where the debtor voluntarily or involuntarily made the transfer or incurred the obligation with the actual intent to hinder, delay or defraud any entity to which the debtor was or thereafter became indebted. The trustee can also avoid any transfer made or obligation incurred where the debtor voluntarily or involuntarily received less than reasonably equivalent value in exchange for such transfer or obligations, and: (i) was insolvent on the date of the transfer or became insolvent as a result of the transfer; (ii) was engaged in, or about to engage in, a business or transaction for which any property remaining with the debtor was an unreasonably small capital; (iii) intended to, or believed it would, incur debts beyond the debtor’s ability to pay as such debts matured; or (iv) made the transfer or incurred the obligation to or for the benefit of an insider under an employment contract and not in the ordinary course of business.

Section 549 of the Bankruptcy Code allows a trustee to avoid any transfer of property of the estate that occurs after the commencement of the case, and (i) is authorized only under Sections 303(f) or 542(c) of the Bankruptcy Code, or (ii) that is not authorized under the Bankruptcy Code or by the Court. Debtors and trustees can recover unauthorized post-petition transfers because, upon the creation of the bankruptcy estate, the bankruptcy court must approve all transfers of estate property outside of the ordinary course of business. Since the Bankruptcy Code requires court approval for nearly all post-petition transactions with a debtor, it provides very limited protection to transferees who deal with the debtor post-petition and without court approval.

II. Assumption or Rejection of Executory Contracts and Unexpired Leases

The Contract Assumption Defense arises by virtue of the trustee’s rights to assume or reject an executory contract or unexpired lease. Section 365(a) of the Bankruptcy Code authorizes the trustee, subject to the court’s approval, to assume or reject any executory contract or unexpired lease of the debtor. If the court grants a motion to assume, pursuant to Section 365(b), the non-debtor counter party has no choice but to continue to perform under the terms of the contract with the debtor. In certain circumstances, the trustee may even assign the contract for profit and the non-debtor counter party must still continue to perform under the contract. In any event, if the bankruptcy court approves the assumption of an executory contract or unexpired lease, the assumption binds the non-debtor counterparty to the agreement.

In order to protect the non-debtor counterparty from undue burden, the Bankruptcy Code set conditions that the trustee must satisfy before assuming any executory contract or unexpired lease. The trustee must: (i) cure, or provide adequate assurance that the trustee will promptly cure, any existing default; (ii) compensate, or provide adequate assurance that the trustee will promptly compensate, the counterparty for any actual pecuniary loss resulting from the default; and (iii) provide adequate assurance of future performance under the contract or lease. Congress passed Section 365 to insure that a contracting party is made whole before a court can force the party to continue performing with a bankrupt debtor. Since the non-debtor counterparty must continue to perform, the assumption gives the contracting party a secured interest in the moneys due to cure existing defaults under the agreement. This distinguishes a non-debtor counterparty to an assumed contract from other general, unsecured creditors.

III. The Contract Assumption Defense

The Seventh Circuit Court of Appeals Contract relied upon the policies behind Section 365 in affirming the bankruptcy court’s application of the Contract Assumption Defense. In Superior Toy, the bankruptcy court approved the debtor’s assumption of a licensing agreement during its chapter 11 bankruptcy case. After conversion, the chapter 7 trustee sought to avoid and recover the payments made under the assumed licensing agreement as preferences. The bankruptcy court dismissed the complaint, finding that the assumption precluded as a matter of law a finding that the pre-petition payments are preferential. The district court affirmed and held that prohibiting preferences against parties to assumed contracts is consistent with the cure requirements of Section 365(b). The Seventh Circuit affirmed, agreeing with the lower courts that Sections 365 and 547 of the Bankruptcy Code were mutually exclusive; thus, the trustee could not sue to recover preferential payments made pursuant to a prior assumption order.

The majority of courts that have addressed the Contract Assumption Defense have agreed with the Seventh Circuit and have held that the Contract Assumption Defense defeats avoidance actions to recover preferential, fraudulent, and unauthorized post-petition transfers. Permitting a preference suit (or other avoidance action) after assumption undermines the Congressional intent and purpose of Section 365. It would prohibit courts from insuring that the trustee’s assumption of an executory contract or unexpired lease gives the other contracting party “the full benefit of his bargain.”

The assumption also negates the fifth element that the trustee must establish to prevail on a preference – i.e., the alternative chapter 7 liquidation element. With respect to fraudulent transfer suits, at least one court failed to comprehend how a trustee can claim that the estate did not receive reasonably equivalent value for making the payments under a contract that was valuable enough for the estate to assume. Since bankruptcy court approval is required before a debtor can assume an executory contract or unexpired lease, there can be no unauthorized post-petition transfers if the bankruptcy court authorizes the assumption.

Ultimately, courts throughout the circuits almost unanimously agree that the Contract Assumption Defense divests a trustee of subsequent claims arising under chapter 5 of the Bankruptcy Code for moneys paid (either prepetition or post-petition) under an assumed agreement. This is an invaluable defense to know and understand when representing parties to executory contracts or unexpired leases. By obtaining an order approving the assumption of an executory contract or unexpired lease, you can obtain a near perfect defense against any future chapter 5 avoidance actions.

 

  1. “Bankruptcy Code” shall mean those chapters and subchapters of title 11, United States Code, 11 U.S.C. § 101 et seq., as amended.
  2. The rights afforded by the Bankruptcy Code to trustees also apply to debtors operating their businesses as debtors-in-possession under 11 U.S.C. §§ 1107 and 1108.
  3. In re Smith, 966 F.2d 1527, 1535 (7th Cir. 1992) (identifying equity of distribution among similarly situated creditors and reducing the incentive to rush to dismember a financially unstable debtor as the two policies underlying the avoidance provisions of the Bankruptcy Code). See also Covey v. Commercial Nat’l Bank of Peoria, 960 F.2d 657, 661-62 (7th Cir. 1992); In re Barefoot, 952 F.2d 795, 797-98 (4th Cir. 1991); H.R. Rep. No. 595, 95th Cong., 2d Sess. 177-78 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6137-39.
  4. Transfers made to “insiders” within one (1) year of the bankruptcy filing are subject to avoidance as preferential transfers. See 11 U.S.C. §§ 101(31), 547(b)(4)(B).
  5. See 11 U.S.C. § 547(b).
  6. See 11 U.S.C. § 547(c)(1)-(9) (providing a complete list of the statutory exceptions to the trustee’s powers to avoid preferential transfers)
  7. See 11 U.S.C. § 548(a)(1)(A).
  8. See 11 U.S.C. § 548(a)(1)(B).
  9. See 11 U.S.C. § 549; see also In re Watson, 65 B.R. 9, 11 (Bankr. C.D. Ill. 1986) (discussing the 4 part inquiry required under Section 549, including (1) whether a transfer of property occurred; (2) whether the property was property of the estate; (3) whether the transfer occurred after the commencement of the case; and, (4) whether the transfer was authorized by the court or the Bankruptcy Code (citations omitted)).
  10. See 11 U.S.C. § 549.
  11. See Szybist v. McKean Cty. Tax Claim Bureau (In re Taft), 262 B.R. 55, 60 (Bankr. M.D. Pa. 2001) (“The purpose of section 549 is to allow the trustee to avoid those post-petition transfers which deplete the estate while providing limited protection to transferees who deal with the debtor.” (citation omitted)).
  12. See 11 U.S.C. § 365(a).
  13. Richmond Leasing Co. v. Capital Bank, N.A., 762 F.2d 1303, 1310 (5th Cir. 1985).
  14. See 11 U.S.C. § 365(c); see also, Matter of Superior Toy & Mfg. Co., Inc. (In re Superior Toy & Mfg. Co.), 78 F.3d 1169, 1172 (7th Cir.1996).
  15. In re Superior Toy & Mfg. Co., 78 F.3d at 1174.
  16. See 11 U.S.C. § 365(b).
  17. In re Superior Toy & Mfg. Co., 78 F.3d at 1174.
  18. Id. at 1172.
  19. Id. at 1774;
  20. Id. at 1176.
  21. Id. at 1170.
  22. In re Superior Toy & Mfg. Co., 78 F.3d at 1170-71.
  23. Id. at 1171.
  24. Id.
  25. Id. at 1174-75.
  26. Id.; Philip Servs. Corp. v. Luntz (In re Philip Servs., Inc.), 284 B.R. 541, 553 (Bankr. D. Del. 2002); Seidle v. Gatx Leasing Corp., 778 F.2d 659, 665 (11th Cir. 1985) (same holding in context of a § 1110 agreement to perform under a lease); Alberts v. Humana Health Plan, Inc. (In re Greater Southeast Cmty. Hosp. Corp.), 327 B.R. 26, 28, 31 (Bankr. D.D.C. 2005); MMR Holding Corp. v. C&C Consultants, Inc. (In re MMR Holding Corp.), 203 B.R. 605, 613 (Bankr. M.D. La. 1996); In re Jazzland, Inc., 2004 Bankr. LEXIS 24, 66, 2004 WL 4945990 (Bankr. E.D. La. 2004); Compton v. Mustang Eng’g Ltd. (In re MPF Holdings US LLC), No. H-13-1964, 2015 U.S. Dist. LEXIS 114987, at *5 (S.D. Tex. Aug. 29, 2015).
  27. In re Superior Toy & Mfg. Co., 78 F.3d at 1174; In re Greater Se. Cmty. Hosp. Corp. 327 B.R. at 31; Weinman v. Allison Payment Sys., LLC (In re Centrix Fin., LLC), 434 B.R. 880, 887-88 (Bankr. D. Colo. 2010).
  28. In re Evans Coal Corp., 485 B.R. 162, 167 (Bankr. E.D. Tenn. 2013)
  29. In re Superior Toy & Mfg. Co., 78 F.3d at 1172; see also Alvarado v. Walsh (In re LCO Enterprises), 12 F.3d 938, 942 (9th Cir. 1993); In re Centrix Fin., LLC, 434 B.R. at 888.
  30. Id. (“The Court fails to comprehend, however, how the Trustee can now claim that the estate did not receive reasonably equivalent value for making payments under a contract that, presumably, was valuable enough to the estate to merit assumption and assignment.”).
  31. See 11 U.S.C. § 365(a).
  32. See 11 U.S.C. § 549.
  33. See In re Kiwi Int’l Air Lines, Inc., 344 F.3d 311, 318-19 (3d Cir. 2003); In re Superior Toy & Mfg. Co., 78 F.3d at 1174-75; In re LCO Enterprises, 12 F.3d at 942; In re Greater Southeast Cmty. Hosp. Corp., 327 B.R. at 31; Schnelling v. Crawford (In re James River Coal Co.), 360 B.R. 139 (Bankr. E.D. Va. 2007); Paradigm Air Carriers, Inc. v. Tex. Rangers Baseball Partners (In re Tex. Rangers Baseball Partners), 521 B.R. 134, 187 (Bankr. N.D. Tex. 2014) (holding that the contract assumption defense would bar a trustee’s avoidance action, where the contract is assumed by the debtor, either under a confirmed plan or prior order of the court); Compton v. Mustang Eng’g Ltd. (In re MPF Holding US LLC), 495 B.R. 303, 323 (Bankr. S.D. Tex. 2013) (“[I]f the Contract was assumed pursuant to section 365, then the contract assumption defense bars the Litigation Trustee from pursuing the instant preference action.”); 3-365 COLLIER ON BANKRUPTCY P 365.06 (15th 2015).

 

Robert S. Bernstein is a two-time Past President of the CLLA, Board-Certified in Business Bankruptcy and Creditors’ Rights by the American Board of Certification, a fellow of the American College of Bankruptcy and Managing Partner at Bernstein-Burkley, P.C. in Pittsburgh, PA.

*This article previously appeared in Commercial Law World, the official publication of the Commercial Law League of America.