United States: In Head-To-Head Contest Between Separate Debtors In Bankruptcy, Right To Reject Executory Contract Prevails

Last Updated: August 10 2016
Article by Joseph A. Florczak

A recent dispute in the U.S. Bankruptcy Court for the Eastern District of Missouri addressed a somewhat novel question of bankruptcy law: What is the proper standard of review when a debtor in a chapter 11 case wants to reject a contract with a counterparty that is also a chapter 11 debtor in a different bankruptcy court and that wishes to assume the same contract? According to the court in In re Noranda Aluminum, Inc., 549 B.R. 725 (Bankr. E.D. Mo. 2016), the "business judgment" standard applies to determine whether rejection should be authorized, rather than a "balancing of the equities" test.

A Sales Contract Burdensome to One Debtor and Essential to Another

The treatment of a long-term sales contract for bauxite used in the initial phases of aluminum manufacturing was the central issue in this duel of competing bankruptcy cases. Noranda Bauxite Ltd. ("NBL") is a debtor affiliate of Noranda Aluminum, Inc. ("Noranda") in their jointly administered chapter 11 cases in the Eastern District of Missouri.

NBL is a Jamaican company whose principal business is the operation of a bauxite mine in Discovery Bay, Jamaica. Bauxite is the principal raw material used in the refining and manufacture of aluminum primary-metals products. NBL's operations provided substantially all the bauxite used in Noranda's upstream primary-metals business, as well as bauxite for sales to third-party metal producers. Among NBL's principal third-party customers was Sherwin Alumina Company, LLC ("Sherwin").

Sherwin's principal business is the operation of a facility to refine bauxite in Gregory, Texas (the "Gregory Facility"). The Gregory Facility is intentionally located on the Gulf of Mexico to facilitate easy access to bauxite mined in Jamaica. The facility was also designed and engineered for the particular features of Jamaican bauxite, which requires more energy and specific processes than bauxite mined in other locations.

In December 2012, NBL and Sherwin entered into a long-term sale-purchase agreement by which Sherwin would purchase bauxite from NBL through 2018 (the "Bauxite Contract"). Under the terms of the Bauxite Contract, Sherwin would purchase bauxite from NBL at a price indexed to Mineração Rio do Norte ("MRN"), a floating reference point that is pegged to the market price for bauxite set by the largest Brazilian bauxite producer. Reflecting the additional effort required to refine Jamaican bauxite as compared to other sources, NBL agreed to a sales price of 73 percent of MRN.

Sherwin viewed the Bauxite Contract as essential to its business viability. The Bauxite Contract provided 65 percent of the total bauxite used in Sherwin's operations. Moreover, Sherwin viewed obtaining bauxite from different sources as wholly impractical, given the location of its operations on the Gulf Coast and because the Gregory Facility is specially engineered to refine Jamaican bauxite. Sherwin estimated that obtaining bauxite from an alternative source might be 50 percent more expensive, not including an estimated $10 million to retool the Gregory Facility to process non-Jamaican bauxite. In brief, without the Bauxite Contract, Sherwin judged that it would likely have to cease operations, which would likely result in the loss of more than 1,000 jobs on the Texas Gulf Coast.

In contrast, NBL viewed the Bauxite Contract as economically burdensome. NBL's cost per ton to mine, process, and transport the bauxite from its Jamaican mines exceeded the sale price. In other words, NBL lost money on every ton of bauxite that it shipped under the terms of the Bauxite Contract with Sherwin. In addition, the terms of NBL's chapter 11 debtor-in-possession ("DIP") financing agreement required NBL to reject the Bauxite Contract. Although NBL did not view the rejection of the Bauxite Contract as a central component of its restructuring, the company determined that rejection of the contract might allow NBL to enter into a new agreement with Sherwin or another third-party buyer at more favorable rates.

Sherwin filed for chapter 11 protection in January 2016 in the Southern District of Texas. In the first days of its bankruptcy case, given the importance of the Bauxite Contract to its operations, Sherwin moved to assume the Bauxite Contract pursuant to section 365 of the Bankruptcy Code. Less than a month later, in February 2016, NBL filed its own chapter 11 case. Contending that the Bauxite Contract was economically unfavorable, NBL sought court authority to reject the Bauxite Contract. Accordingly, the conflicting motions set up a duel between the two chapter 11 cases.

Assumption and Rejection Under Section 365 of the Bankruptcy Code

Under section 365 of the Bankruptcy Code, a bankruptcy trustee or DIP may, among other things, "assume" or "reject" executory contracts or unexpired leases (agreements with respect to which material obligations remain for each contract party). Generally speaking, the assumption of an executory contract or unexpired lease restores the terms and enforceability of the agreement, provided that any defaults under the agreement are cured, among certain other conditions. In contrast, the rejection of an executory contract operates as a deemed breach of the contract effective immediately before the filing of the bankruptcy petition, with the nonbreaching counterparties receiving prepetition damages claims on account of such rejection in the bankruptcy case.

The underlying policy consideration of this framework is to allow a trustee or DIP to maximize the value of the bankruptcy estate by assuming contracts that are beneficial to the bankruptcy estate and rejecting contracts that pose an economic burden to the estate.

The Business Judgment Standard

In nearly every circumstance, a bankruptcy court will evaluate a decision by a trustee or DIP to assume or reject a contract according to the "business judgment" standard. Under this deferential standard, the court will not substitute its own judgment so long as the decision reflects a rational business purpose and lacks any indicia of fraud, insider dealing, or other forms of abuse.

In the Eighth Circuit, which encompasses the district where Noranda's chapter 11 case is pending, the business judgment standard has two prongs: the assumption or rejection must (i) be in the exercise of sound business judgment, showing benefit to the estate; and (ii) not involve bad faith or gross abuse of business discretion. See In re Crystalin, L.L.C., 293 B.R. 455 (B.A.P. 8th Cir. 2003).

Balancing of the Equities Test

In its objection to NBL's motion to reject the Bauxite Contract, Sherwin argued that a "balancing of the equities" test should be applied in cases where one chapter 11 debtor seeks to assume a contract which another chapter 11 debtor seeks to reject, citing the 1980s-era decisions in In re Midwest Polychem, Ltd., 61 B.R. 559 (Bankr. N.D. Ill. 1986); In re H.M. Bowness, Inc., 89 B.R. 238, 242 (Bankr. M.D. Fla. 1988); and In re Sun City Investments, Inc., 89 B.R. 245, 249 (Bankr. M.D. Fla. 1988). Under this test, Sherwin argued, the court should balance the relative benefits and/or harms to each of the bankruptcy estates that would be caused by assumption or rejection of the contract at issue. Using such a framework, Sherwin maintained, a court could properly deny rejection of a contract if rejection would "mortally wound" the business of one chapter 11 debtor and produce only a marginal benefit for the other chapter 11 debtor.

The Bankruptcy Court's Ruling—The Business Judgment Test Prevails

The Noranda Aluminum bankruptcy court declined to adopt the balancing of the equities test, noting that the cases applying it were neither current nor binding precedent. Moreover, the court observed that the Midwest Polychem court did not choose between the business judgment standard and the balancing of the equities test, as that court's determination was the same under either standard. The Noranda Aluminum court also noted that a careful reading of H.M. Bowness and Sun City indicates that those courts actually applied the business judgment standard.

The Noranda Aluminum court also rejected Sherwin's arguments in the alternative, asserting that application of the business judgment standard in this "extreme case" would require consideration of the potential impact on the contract counterparty in certain exceptional circumstances. The court acknowledged that a higher standard may apply when a debtor's authority to reject a contract would conflict with "policies designed to protect the national interest underlying federal regulatory schemes." However, it found that no such interests were implicated in NBL's proposed rejection of the Bauxite Contract. According to the court, the Bankruptcy Code creates special protections for certain types of executory contracts or unexpired leases, including intellectual property license agreements (section 365(n)), collective bargaining agreements (section 1113), aircraft leases (section 1110), and railroad line leases (sections 1165 and 1169), none of which the Bauxite Contract implicated.

Outlook

Despite the court's professed sympathy for Sherwin's plight, its analysis in Noranda Aluminum adheres closely to the long-established principles and policy rationale of the business judgment rule. The court flatly rejected the argument that a court must consider the impact of the rejection of a contract on the contract counterparty, at least under the circumstances presented. The ruling suggests that, in competing bankruptcy cases, a trustee or DIP's right to reject an executory contract or unexpired lease as an exercise of business judgment trumps the desire of a different trustee or DIP to assume the same contract.

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.

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