What happens if a debtor’s executory contract terminates or expires of its own terms, after the debtor’s bankruptcy case is filed (while the contract is still executory) but before the debtor moves to reject the agreement? This situation presents one of the more difficult problems for a debtor and the contract counter-party.
In Agarwal v. Pomona Valley Med. Group, Inc. (In re Pomona Valley Med. Group, Inc.), 476 F.3d 665 (9th Cir. 2007), the debtor, Pomona Valley, had entered into a provider agreement with Dr. Agarwal, a primary care physician and certified cardiologist. Agarwal provided basic medical services, but when a patient required specialty medical services, Agarwal was required to seek authorization from Pomona Valley’s Medical Director. The provider agreement had an initial 12-month term and extended automatically for an unlimited number of additional 12-month terms, unless Pomona Valley gave Agarwal written notice of non-renewal.
Shortly before Pomona Valley filed its bankruptcy case under chapter 11, the contract automatically renewed for a second one-year term. Pomona Valley began denying authorization for certain cardiology tests for Agarwal’s patients. Pomona Valley warned Agarwal that it viewed his frequent ordering of tests as unnecessary and believed it was being done simply to increase Agarwal’s income. Eventually, Pomona Valley sent Agarwal notice that Pomona Valley did not agree to a renewal of the contract at the end of the second year.
Following the expiration of the second year, Agarwal filed an adversary proceeding in the bankruptcy court alleging California statutory and common law causes of action, some based on the provider agreement. Agarwal claimed damages for retaliatory termination of the contract in violation of California Business & Professions Code provisions; violation of the notice and hearing requirements applicable to health care providers under the same Code; violation of California’s common law right to a fair procedure in employment termination; breach of the notice requirements of the executory contract; unfair competition in violation of California’s Business & Professions Code § 17200; and interference with prospective business advantage.
Pomona Valley moved for bankruptcy court approval of its rejection of the expired provider agreement, effective as of the filing of the bankruptcy case.
It also moved to dismiss the adversary proceeding on the grounds that the court-approved rejection collaterally estopped Agarwal from his claims. The bankruptcy court approved the rejection and granted the dismissal of Agarwal’s complaint, and the district court affirmed. Agarwal appealed to the U.S. Court of Appeals for the Ninth Circuit.
The Ninth Circuit first examined the rejection of the provider agreement and upheld Pomona Valley’s right to reject the executory contract. Bankruptcy Code section 365(a) gives a debtor, subject to court approval, the power to reject any executory contract. But the drafters of the Bankruptcy Code left it to the courts to define an executory contract. The most widely accepted formulation is that posited by Professor Vern Countryman in "Executory Contracts In Bankruptcy: Part I," 57 Minn. L. Rev. 439 (1973), in which he defined an executory contract as a contract in which obligations remain to be performed by both sides at the time the "executoriness" decision is made.
Accordingly, a contract is considered executory in a bankruptcy case only if it was executory on the day that the bankruptcy case was filed. In re Robert L. Helms Constr. and Dev. Co., 139 F.3d 702, 706 (9th Cir. 1998) (en banc); In re Coast Trading Co., 744 F.2d 686, 692-3 (9th Cir. 1984). Thus, even though a contract is no longer executory, a debtor still could reject it because it was executory when bankruptcy was filed.
In Pomona Valley, the court had no quarrel that the rejection was proper. The standard of review by the bankruptcy court is the business judgment rule. Pomona Valley, 476 F.3d at 674. And the contours of the business judgment rule in the bankruptcy context are the same as they are in corporate litigation and fiduciary matters. Pomona Valley, 476 F.3d at 675, citing Lubrizol Enter. v. Richmond Metal Finishers, 756 F.2d 1043, 1047 (4th Cir. 1985).
The bankruptcy court correctly presumed that Pomona Valley acted prudently in deciding to reject the contract; that it acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the estate. Id.
To second-guess the debtor, the courts would need to find that the debtor’s conclusion is "so manifestly unreasonable that it could not be based on sound business judgment but only on bad faith, or whim or caprice." Id.; Lubrizo, 756 F.2d at 1047. There being no record of such bad judgment, the Ninth Circuit affirmed the rejection.
Pomona Valley argued that contract rejection meant Agarwal’s complaint should be dismissed.
The Ninth Circuit agreed in part and disagreed in part. Certain of Agarwal’s claims for relief were disposed of by contract rejection. For example, Agarwal’s claim for relief that Pomona Valley breached the notice requirements of the provider agreement, itself, is overridden by the rejection procedure allowed under the Bankruptcy Code. Bankruptcy court approval of rejection trumps any notice requirements in the contract itself. The Ninth Circuit extended that holding to cover special California statutory law notice and hearing requirements for the discharge of medical professionals and California common law rights to a fair procedure in connection with such a discharge.
Nevertheless, the rejection of the contract did not protect Pomona Valley against Agarwal’s claims that his termination was (1) retaliatory in nature and thus in violation of the Business & Professions Code §2056; (2) unfair competition under Business & Professions Code §17200; and (3) common law interference with his prospective business advantage. The Ninth Circuit reasoned that rejection of an executory contract does not otherwise affect the parties’ substantive rights under the contact or applicable state law. Pomona Valley, 476 F.3d at 680; In re Onecast Media, Inc., 439 F.3d 558, 563 (9th Cir. 2006).
Therefore, certain causes of action could survive a proper rejection of an executory contract. The Ninth Circuit held that Agarwal’s complaint sufficiently alleged that by rejecting the contract, Pomona Valley retaliated against him for advocating for medically appropriate health care for his patients—a violation of the statute. The retaliatory termination allegations also support a claim for violation of §17200, which forbids any unlawful, unfair or fraudulent business practice. Retaliatory termination could be an unfair business practice.
Finally, the court found that Agarwal’s allegation that the retaliatory termination was misleading to the public in general was sufficient to support an unlawful interference claim.
While not remarkable on its face, the Ninth Circuit’s holding seems incongruous and perhaps internally inconsistent. How can the decision made by Pomona Valley, which the court held to be "prudent," on an informed basis, "in good faith" and taken in the honest belief that the action was in the best interest of the bankruptcy estate, also be a violation of a state statute, statutory unfair competition, and a common law tort, all subjecting the debtor to claims for large sums of damages? The opinion is silent on that question.
Moreover, the decision is silent on whether the damages claimed by Agarwal are pre- or post-petition claims. Damages for rejection of an executory contract are pre-petition claims because the rejection is deemed effective the day before the bankruptcy case is filed. If the rejection is the breach, those damages are pre-petition and pro-rated with other pre-petition debt. Post-petition claims generally are administrative in nature and usually paid in full.
If the rejection of the contract is not just a breach, but also some other type of wrong—an unfair competition violation, for example, the damages may qualify as post-petition claims that must be paid in full. Agarwal raised the question of pre- versus post-petition damages in his opening brief on appeal, but the opinion is silent about the topic, leaving unresolved the question of whether a proper rejection of an executory contract can give rise to an administrative expense claim for damages as well as a pre-petition claim.
The cautionary tale here is that the findings implicit in a bankruptcy court’s decision to approve the rejection of an executory contract–prudence, good faith, knowledge and an honest belief that the best interests of the estate are served–will not conclusively defeat claims of the contract counter-party for damages based on debtor’s alleged bad conduct in the decision to reject the contract. The bankruptcy court’s blessing of that decision simply may be not nearly as protective as it first seems.
This article is presented for informational purposes only and is not intended to constitute legal advice.
