Whether a contract is "executory" such that it can be assumed, rejected, or assigned in bankruptcy is a question infrequently addressed by the circuit courts of appeals. The U.S. Court of Appeals for the Third Circuit provided some rare appellate court-level guidance on the question in Spyglass Media Group, LLC v. Bruce Cohen Productions (In re Weinstein Company Holdings LLC), 997 F.3d 497 (3d Cir. 2021). The Third Circuit affirmed lower court rulings holding that a "work-made-for-hire" contract between a film company debtor and the producer of a motion picture was not an executory contract because the producer lacked any remaining "material obligations." In so ruling, the court noted that the parties to a contract can override the Bankruptcy Code's intended protections for a debtor in connection with certain contracts, but only by clearly and unambiguously providing that continuing obligations are material in the text of the agreement and thereby ensuring to the maximum extent possible that the contract will be found to be executory.
Assumption and Rejection of Executory Contracts and Unexpired Leases
Section 365(a) of the Bankruptcy Code provides that, with certain exceptions delineated elsewhere in the statute, "the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor." The trustee's power to assume or reject is conferred upon a chapter 11 debtor-in-possession ("DIP") under section 1107(a) of the Bankruptcy Code. Rejection results in a court-authorized breach of the contract, with any claim for damages treated as a prepetition claim against the estate on a par with the claims of other general unsecured creditors (unless the debtor has posted security). 11 U.S.C. § 365(g). Assumption of a contract requires, among other things, that the trustee or DIP cure all existing monetary defaults and provide adequate assurance of its future performance. 11 U.S.C. § 365(b).
Bankruptcy courts will generally approve assumption or rejection of an executory contract if presented with evidence that either course of action is a good business decision. See Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652, 1658 (2019) ("The bankruptcy court will generally approve [the] choice [to assume or reject], under the deferential 'business judgment' rule."). Upon assumption, most kinds of executory contracts may also be assigned by the trustee or DIP to third parties under the circumstances specified in sections 365(c) and 365(f). In chapter 11 cases, except with respect to certain kinds of contracts (such as nonresidential real property leases, aircraft lease agreements, and commitments to a federal depository institutions regulatory agency), the trustee or DIP may decide to assume or reject at any time up to confirmation of a chapter 11 plan. However, any nondebtor party to a contract may seek to compel the trustee or DIP to assume or reject the contract prior to confirmation, in which case the bankruptcy court must decide what period of time is reasonable to make the decision. 11 U.S.C. §§ 365(d)(2), (d)(4), and (o). Pending the decision to assume or reject, the trustee or DIP is generally obligated to keep current on most obligations that become due under the contract postpetition. 11 U.S.C. §§ 365(d)(3) and (d)(5).
Definition of "Executory"
The Bankruptcy Code does not define "executory." Based on the legislative history of section 365, the U.S. Supreme Court concluded in a 1984 decision that "Congress intended the term to mean a contract 'on which performance is due to some extent on both sides.'" NLRB v. Bildisco & Bildisco, 465 U.S. 513, 522 n.6 (1984) (quoting H.R. Rep. No. 95-595, 347 (1977); S. Rep. No. 95-989, 58 (1978)).
However, because nearly all contracts involve some unperformed obligations on both sides as of the bankruptcy petition date, many courts have adopted the more restrictive definition proposed by Professor Vern Countryman, who in 1973 defined an "executory" contract as "[a] contract under which the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other." See V. Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973); see also V. Countryman, Executory Contracts in Bankruptcy: Part II, 57 Minn. L. Rev. 479 (1974); see generally Collier on Bankruptcy ("Collier") ¶ 365.02 (16th ed. 2021) (citing cases).
Thus, according to this approach, unless both parties have unperformed obligations as of the bankruptcy petition date that would constitute a material breach if not performed, the contract is not executory. See In re Columbia Gas Sys. Inc., 50 F.3d 233, 239 (3d Cir. 1995); accord In re Bennett Enterprises, Inc., 628 B.R. 481 (Bankr. D.N.J. 2021) (a contract for the sale of a debtor's liquor license did not remain executory after the purchaser obtained a state court order for specific performance because, under New Jersey law, neither party had any remaining material obligations to the other under the sale contract, and to the extent either party failed to fulfill its obligations under the state court order, the state court had authority to complete, or appoint a third party to complete, those obligations); see also In re Brick House Properties LLC, 2021 WL 3502914, *6 (Bankr. D. Utah June 11, 2021) (noting that, in accordance with the Tenth Circuit's ruling in In re Baird, 567 F.3d 1207 (10th Cir. 2009), the Countryman definition applies, but with the caveat that the remaining obligations must be "significant").
State law determines what constitutes a material unperformed obligation. Columbia Gas, 50 F.3d at 239 n.10; In re Houston, 2009 WL 3762257, at *2 (Bankr. W.D. Ky. Nov. 9, 2009) ("Whether a party's nonperformance of the remaining obligations under a contract would constitute a material breach is a factual question resolved through application of state law.") (citing In re Teligent, Inc., 268 B.R. 723, 730 (Bankr. S.D.N.Y. 2001)); Seitz v. Paul T. Freund Corp., 2009 WL 1011617, at *2 (W.D.N.Y. Apr. 15, 2009) ("Determination of whether a breach is material is a factual question resolved by resort to state law.... In New York, a material breach is one which substantially defeats the purpose of the contract, and if uncured, will operate to excuse the other party from further performance.").
Some courts have eschewed the traditional Countryman test in favor of a result-oriented or "functional" approach examining whether the bankruptcy estate will benefit from assumption or rejection of the contract instead of looking at the mutuality of unperformed material obligations. See In re Fin. Oversight & Mgmt. Bd. for Puerto Rico, 2021 WL 2676983, *4 (D.P.R. June 29, 2021) (noting that the functional approach works "'backward from an examination of the purposes to be accomplished by rejection, and if they have already been accomplished then the contract cannot be executory'" (citation omitted) and ruling that a prebankruptcy settlement agreement was executory and could be assumed under either the Countryman or the functional test); see generally Collier at ¶ 365.02 (citing cases).
Yet another approach is a "modern contract analysis" proposed by Professor Jay L. Westbrook and Kelsi S. White in their article titled "The Demystification of Contracts in Bankruptcy," 91 Am. Bankr. L.J. 481 (Summer 2017), which is premised on the notion that the Countryman test is outmoded and confusing. This approach would abolish the "material breach" rule that embodies executoriness as a prerequisite to application of section 365. Instead, the court would engage in the following analysis to determine whether a contract should be assumed or rejected:
(1) Determine under state contract law if the contract contains some obligations that remain to be performed. If not, it cannot be assumed or rejected;
(2) If there is nothing remaining under the contract except obligations owed by the debtor (e.g., payment), assumption or rejection is not necessary because there is nothing left to do except payment and discharge through the bankruptcy process;
(3) If some obligations remain other than mere payment, consider whether the net benefit to the estate from performance by both parties (assumption) exceeds the net benefit from the estate's breach of the contract and payment of the breach (rejection) claim; and
(4) The court should approve the course of action resulting in net benefit to the estate, unless some other specific provision in section 365 requires a different conclusion.
Id. at 489.
If a contract or agreement is not executory, it may be neither assumed nor rejected. Instead, the contract may give rise to either an estate asset or a liability-in the latter case, a claim that may be asserted against the estate by the non-debtor party. Thus, for example, if the non-debtor party has fully performed under the contract and "the only remaining obligation is the [debtors'] duty to pay," the contract is not executory. Teligent, 268 B.R. at 732; accord Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1046 (4th Cir. 1985) ("It is true that a contract is not executory as to a party simply because the party is obligated to make payments of money to the other party.").
However, like other assets of a bankruptcy estate, a contract that is not executory may be sold by the trustee or DIP as part of a chapter 11 plan or in a sale under section 363 of the Bankruptcy Code. In the event of a sale "free and clear" under section 363(f), the trustee or DIP need not cure any defaults under the contract, and, unless the parties agree otherwise, the buyer would not assume any prepetition liabilities under the contract. See In re Am. Home Mortg. Holdings, Inc., 402 B.R. 87, 94 (Bankr. D. Del. 2009) ("[S]ection 363 of the Bankruptcy Code permits a debtor to transfer its rights and obligations under a non-executory contract ... [and] section 363(f)(5) permits the rights and obligations under one non-executory contract to be transferred free and clear of claims arising under other contracts."); accord In re Badlands Energy, Inc., 608 B.R. 854, 874 (Bankr. D. Colo. 2019).
Weinstein
In 2011, Bruce Cohen ("Cohen") and his production company entered into an agreement ("Cohen agreement") with the predecessor-in-interest of The Weinstein Company ("TWC") to make the film Silver Linings Playbook. The contract was structured as a "work-made-for-hire," meaning that Cohen owned none of the intellectual property in the picture but was paid $250,000 in fixed initial compensation and had the right to contingent future compensation equal to approximately 5% of the picture's future profits. The contingent compensation provision stated that, if the film was produced by Cohen, and Cohen and his production company fully performed all required services and obligations under the agreement, "and are not otherwise in breach or default hereof," Cohen was entitled to the specified contingent compensation.
The film was successfully released in 2012.
In March 2018, TWC filed for chapter 11 protection in the District of Delaware for the purpose of selling its assets under section 363 of the Bankruptcy Code to Spyglass Media Group, LLC ("Spyglass"). At the time of the bankruptcy filing, Cohen was owed approximately $400,000 in profits from the film. The sale closed in July 2018. Under the asset purchase agreement, Spyglass agreed to pay any cure amounts necessary under assumed executory contracts. However, Spyglass had until November 2018 to designate which TWC executory contracts it wanted to assume as part of the transaction. In October 2018, Spyglass sought a declaratory judgment from the bankruptcy court that the Cohen agreement was not executory and, therefore, could not be assumed and assigned (with an attendant cure obligation) but was part of the section 363 sale.
Cohen objected. Other writers, producers, and actors with similar work-made-for-hire contracts similarly asserted that their contracts were executory and that Spyglass owed them millions of dollars in contingent compensation incident to TWC's cure obligations under section 365(b).
In a test case for these disputes, the bankruptcy court ruled that the Cohen agreement was not executory and thus could be sold under section 363 to Spyglass without triggering a cure payment obligation. The district court affirmed, and Cohen appealed to the Third Circuit.
The Third Circuit's Ruling
At the outset of its opinion, the Third Circuit explained that, if the Cohen agreement was executory, Spyglass had to cure existing defaults and pay approximately $400,000 in contingent compensation to Cohen. If the contract was not executory, Spyglass needed to comply only with post-closing obligations coming due under the agreement.
Writing for the three-judge panel, Circuit Judge Thomas L. Ambro noted that New York law governed the Cohen agreement. This meant that the court was required to analyze whether the agreement "contained at least one obligation for both [TWC] and [Cohen] that would constitute a material breach under New York law if not performed." Weinstein, 997 F.3d at 503 (citation and internal quotation marks omitted). Under New York law, Judge Ambro explained: (i) "[a] material breach is a failure to do something that is so fundamental to a contract that the failure to perform that obligation defeats the essential purpose of the contract"; and (ii) in accordance with the substantial performance doctrine, if the defaulting party has substantially performed, the other party is not excused from performing. Id.
According to Judge Ambro, TWC's obligation to pay contingent compensation to Cohen was "clearly material" because it far exceeded Cohen's fixed compensation under the Cohen agreement. However, Cohen's remaining obligations, including his agreement to refrain from seeking injunctive relief about the exploitation of the film, his obligation to indemnify TWC against third-party claims arising from any breaches committed by him, and restrictions on his ability to assign the contract, were "all ancillary after-thoughts in a production agreement." Id. at 507.
Judge Ambro rejected Cohen's argument that the court could not substitute its own judgment because Cohen and TWC expressly agreed that all of Cohen's obligations under the Cohen agreement were material in the provision requiring TWC to pay his contingent compensation if he was "not otherwise in breach or default." Judge Ambro acknowledged that parties can contract around a default rule such as the substantial performance rule-i.e., "they can agree that what to the ordinary person is immaterial is nonetheless not so"-and that if a contract "makes plain that certain unperformed obligations are material, we can conclude that the contract is executory without further analysis." Id. (citations omitted). However, he concluded that the parties to the Cohen agreement did not "clearly and unambiguously avoid the substantial performance rule for evaluating executory contracts." Id. at 508.
Among other reasons, Judge Ambro explained: (i) the language relied on by Cohen for the materiality of his remaining obligations was "buried in a long covenant provision" rather than being part of the remedies or termination section of the contract; and (ii) the requirement that Cohen not be in breach or default "may be better viewed as a condition precedent to TWC's payment obligation" than a duty or an obligation, indicating that the contract was not executory. Id.
Finally, Judge Ambro noted that, if accepted, Cohen's position would permit the contract parties to override debtor protections in the Bankruptcy Code:
[T]he Code's treatment of contracts facilitates the debtor's rehabilitation by treating non-executory contracts where only the debtor has material obligations to perform as liabilities of the estate, so the debtor does not accidentally assume them without good reason. Here, the logical implication of Cohen's position is that the Cohen Agreement would be an executory contract forever, no matter how much he has already performed.... That would be a highly unusual result and would contravene the protections created for the Debtors by the Bankruptcy Code....
To be clear, we recognize that parties can contract around a state's default contract rule regarding substantial performance, and by doing so they can also override the Bankruptcy Code's intended protections for the debtor. However, that result can only be accomplished clearly and unambiguously in the text of the agreement.
Id. at 509. The Third Circuit accordingly affirmed the lower courts' determinations that the Cohen agreement was not an executory contract.
Outlook
Weinstein does not break any new ground on the definition of an executory contract that may be rejected, assumed, or assumed and assigned in a bankruptcy case. Even so, the ruling is notable because it provides rare appellate court-level guidance on the issue. It also highlights that parties may, through clearly drafted provisions, specify those obligations that they intend to be material under an agreement that may end up as part of a bankruptcy estate.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
TELIGENT 