A financially distressed company seeking refuge in Chapter 11 bankruptcy can take advantage of rights and remedies that are unavailable anywhere else. Need to stop a state court lawsuit in its tracks? Bankruptcy and the imposition of the automatic stay can do that. Need to force a lender or a trade creditor to accept worse treatment that what was originally agreed? Confirm a “cram down” plan of reorganization over the other party’s objection and emerge from bankruptcy with a new and enviable balance sheet. Need a particular agreement to effectively operate your business, but the counterparty terminated the agreement prior to the bankruptcy filing? If the agreement truly was terminated, then a bankruptcy filing will offer the debtor no succor. The power of Chapter 11 may heal the financially lame, but it cannot resurrect a dead contract.

A debtor’s ability to continue operating under the terms of an agreement can make the difference between whether a Chapter 11 bankruptcy makes sense in the first place. Understanding a few basic bankruptcy concepts and terms is necessary to set the stage. First, an agreement between a debtor and non-debtor party that has material unperformed obligations by both parties as of the date of the bankruptcy filing is called an “executory contract.” Bankruptcy provides debtors with the ability to either assume or reject an executory contract or a lease. Assumption and rejection is a very important part of most every bankruptcy case. Consider, for example, a retailer that is party to supply agreements vendors in several different regions of the country. Business is great in one region, and terrible in another region. The retailer may decide to make use of Chapter 11 by seeking to assume the supply agreements in the good region and rejecting the agreements in the bad one. Assumption of the agreements will require the debtor to pay the non-debtor party any past due amounts and further to provide each non-debtor party with adequate assurance of future performance. Essentially, the debtor must demonstrate to the other party that it will have the financial wherewithal to perform going forward. As to the rejected agreements, the non-debtor party will have a claim related to the lost income it expected to receive over the remaining life of the agreement (in other words, breach of contract damages). But, such damages are deemed to be merely unsecured claims and in many cases unsecured claims are paid at pennies on the dollar. Generally speaking, the same rules apply to real property lease assumptions and rejections, although there is a statutory cap that limits lease rejection damages to the greater of one year of rent or 15% of the remaining lease term rent, not to exceed three years’ worth.

A debtor is not required to make the assumption/rejection decision immediately following the bankruptcy filing. Rather, in a Chapter 11 case, the debtor can delay the decision until confirmation of a plan. Depending on the case, plan confirmation make time quite some time. During the period prior to assumption or rejection, the non-debtor party is required to continue performance. The debtor, for its part, is not strictly required to perform under the agreement, but is required to pay the non-debtor party the value for the benefits provided to the bankruptcy estate. While the benefit to the estate is not necessarily the same as the payment terms under the agreement, in practice debtors typically continue to pay the non-debtor party under those terms.

During the pre-assumption/rejection time period, the non-debtor party is therefore protected from the standpoint of continuing to receive payments. However, the non-debtor party must deal with the uncertainty associated with not knowing whether it will remain in a long term contractual relationship with the debtor. If such uncertainty is causing actual damage to the non-debtor party’s business (as opposed to merely nervousness or inconvenience), the non-debtor party’s remedy is to seek an order from the bankruptcy court compelling the debtor to decide whether to assume or reject the agreement. In addition, the Bankruptcy Code provides additional “safe harbor” rights to non-debtor parties (which will be the subject of a future blog post) in relation to certain types of financial and commodity agreements. Safe harbor provisions allow the non-debtor party to terminate or otherwise enforce agreement terms in a manner unavailable to non-debtor parties of typical executory contracts.

Only executory contracts that are property of a debtor’s bankruptcy estate are subject to assumption or rejection. An agreement becomes property of the estate if the debtor had any interest in the agreement as of the bankruptcy filing. Thus, for example, if the non-debtor party sends the debtor a default letter with a ten day cure period and the debtor files bankruptcy on day nine, the bankruptcy filing stops the clock and the agreement becomes part of the bankruptcy estate. Likewise, if the agreement has a provision that it automatically terminates upon a bankruptcy filing, it still becomes part of the estate because such “ipso facto” clauses are not enforceable in bankruptcy.

If, however, the debtor files on day eleven following a ten day cure period, then the agreement terminated according to its terms prior to the bankruptcy filing and it does not become property of the bankruptcy estate. The debtor will have no rights under the agreement and the non-debtor party will not be bound by the automatic stay (although many non-debtors in such a situation nevertheless seek stay relief out of an abundance of caution). Note, however, that the situation may not be as clear-cut as it seems. For example, if the non-debtor party continued to act as though an agreement existed following the termination, a bankruptcy court could find that some sort of enforceable agreement between the parties existed as of the filing date. The non-debtor party should also be mindful of a waiver argument. That is, if the termination date passes and the non-debtor party takes no action to enforce the termination, then the debtor may argue that the non-debtor waived its rights and the agreement remained in existence at the time of the filing.

This dynamic gives rise to a number of strategic considerations. On the debtor side, quickly filing bankruptcy before the non-debtor can effectuate a termination may be one of the best decisions a debtor makes. On the other side, a non-debtor seeking to avoid several months of dealing with a bankruptcy case will want to fully and finally terminate an agreement well before a prospective debtor wakes up to the severity of the situation. The party who realizes what is at stake and takes decisive and effective action likely will be the one with the upper hand. The general takeaway for debtors and non-debtors alike is to read and understand the contract, determine whether it may qualify for safe harbor protections, don’t sleep on your rights, and understand that delaying the exercise of your rights is risky business.

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