The Bankruptcy Code allows a debtor to assume or reject executory contracts and unexpired leases before the confirmation of a plan of reorganization. The Code does not define executory contracts, but courts generally characterize them as contracts for which performance remains due to some extent on both sides.

If the debtor elects to assume an executory contract, it must continue its performance and cure all defaults. When the debtor rejects the contract, however, it elects to breach its obligations. If the debtor rejects the contract, the nondebtor party does not lose all its rights, but the court reduces the contractual obligations to general unsecured claims for breach of contract.

For obvious reasons, these nondebtor parties might prefer the debtor to accept, rather than reject, the executory contract.

The Code and related case law make it clear that the right to assume or reject executory contracts rests with the debtor. The Code does not, however, grant the debtor the ability to reject non-executory contracts, under which one party already has performed all of its obligations.

This raises the question of whether a nondebtor party to an executory contract can usurp the power of the debtor in bankruptcy to reject an executory contract by completing its performance obligations post-petition—thereby converting the executory contract into a non-executory one. A recent opinion by the U.S. Court of Appeals for the Second Circuit answers this question in the negative.

Attempted Conversion

In re Penn Traffic Co., 524 F.3d 373 (2d Cir. 2008), involved a dispute between COR, a commercial real estate developer, and The Penn Traffic Company, a food retailer. Penn Traffic wanted to expand and modernize its supermarket. To do so, it needed to acquire or utilize an adjacent tract of land owned by COR. The two parties entered into what the court called a "Project Agreement," whereby the parties agreed to swap certain parcels of land in exchange for certain other obligations.

As per the Project Agreement, Penn Traffic would construct a modern supermarket, COR would reimburse Penn Traffic for a specified portion of the construction costs, Penn Traffic then would convey the parcel of land on which the supermarket was situated to COR, and Penn Traffic would lease back the improved supermarket parcel from COR. This transaction proceeded smoothly until Penn Traffic filed for chapter 11 bankruptcy.

At the time Penn Traffic filed for bankruptcy, COR had performed all of its duties under the Project Agreement, except for the reimbursement of the construction costs (amounting to approximately $3.5 million) and the tender of a lease to Penn Traffic. After Penn Traffic filed for bankruptcy, but before it could assume or reject the Project Agreement, COR attempted to complete its performance by tendering to Penn Traffic reimbursement of the $3.5 million in construction costs, as well as a signed lease.

Penn Traffic, however, rejected this tender and later moved pursuant to section 365 of the Bankruptcy Code to reject the Project Agreement. After some procedural pinball, the issue of whether COR's tender converted the Project Agreement into a non-executory contract came before the Second Circuit.

'Executoriness' Issue

COR maintained that the Project Agreement was not an executory contract at the time of filing, but the Second Circuit quickly and unceremoniously rebuffed these arguments by summarizing the district court's analysis. The real meat of In re Penn Traffic comes from the court's analysis of the more novel "executoriness" issue.

The court concluded that a nondebtor party to an executory agreement cannot force a debtor to accept a contract by completing its performance. Resting its holding in the language of the Code and the policy behind section 365, the court stated:

Sympathy for the nondebtor that may, through no fault of its own, bear some significant burden from the debtor's rejection of an executory contract due to the happenstance of an unforeseen bankruptcy proceeding is understandable. The notion that a nondebtor could prevent the exercise of § 365 rights with regards to an executory contract through post-petition performance of the non-debtor's contractual obligations is, however, inconsistent with both the plain language and the policy of the Code.

As for the language of the statute, §§ 365 and 1107 expressly permit a chapter 11 debtor to move to assume or reject an executory contract at any time before the confirmation of a plan unless the court orders it to make an earlier determination. The Code does not condition the right to assume or reject on lack of prejudice to the non-debtor party, and the satisfaction of claims at less than their full non-bankruptcy value is common in bankruptcy proceedings, as is the disruption of non-debtors' expectations of profitable business arrangements.

With this ruling, the Second Circuit reaffirmed the debtor's right and providence to elect to assume or reject an executory contract, stating:

"The main purpose of [s]ection 365 is to allow a debtor to reject executory contracts in order to relieve the estate of burdensome obligations while at the same time providing a means whereby a debtor can force others to continue to do business with it when the bankruptcy filing might otherwise make them reluctant to do so."

In so holding, the court clarified that section 365 permits the debtor to examine its inventory of executory contracts, and decide which ones it would benefit by assuming, and which ones it would benefit by rejecting. While this process may take some time, it is the debtor's—and only the debtor's—right to make this election.

This article is presented for informational purposes only and is not intended to constitute legal advice.