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There is No Sanity Clause – Performance of Contracts in Bankruptcy

On Behalf of | May 14, 2020 | Firm News

Written by George R. Pitts

There is a famous scene in the Marx Brothers’ film Night at the Opera in which Groucho, representing an opera company, tries to get Chico, representing a singer, to sign his singer up with the opera company.   They begin with a lengthy contract on legal-size paper and as Chico reviews and rejects the various provisions, Groucho tears them off, until he is left only with a thin horizontal bit of the document. He tells Chico that he (Chico) has got to like this one, because it merely requires each party to represent that he/she is of sound mind. Chico is adamant in rejecting this clause: everyone knows there is no “Sanity Clause.” After reviewing the rest of this piece, the reader may feel just like Chico.

As we are warned of an avalanche or tsunami of bankruptcy cases (depending upon one’s preference for earth or sea), it will be useful to look at a situation that could face any business at any time: a customer, a supplier or a vendor files for bankruptcy with the objective of getting rid of all that pesky debt, cleaning up an ugly balance sheet and having a fresh start. Usually, when this happens, the bankrupt is already in default under your contract: for example, it has not paid for things you sent or it has not sent items that you paid for and you are prevented from doing anything about it by the automatic stay of creditor action against the debtor after bankruptcy is filed.

Let us also say that you as a supplier, in order to compete effectively in a tough marketplace, gave terms to the debtor – let us say 30-day terms – and that the debtor orders more than $1 million in products from you during a given 30-day period (that is part of the reason that you gave the debtor terms). Now, however, the debtor has filed a bankruptcy case, owing you almost $1 million for products already sent, and now contacts you asking that you continue to ship on terms. You throw the cell phone across the room and don’t think about this situation any longer because it is so ridiculous. Then papers are delivered to you in the debtor’s bankruptcy case, demanding performance under your contract. Do you treat the lawsuit the same way you did the cell phone? As you may guess because this article appears in a law firm blog, the answer is no.

Many business debtors file for bankruptcy not only because they have substantial debts but also because they are parties to bad contracts with suppliers, other businesses or landlords. Think of a retailer that is paying too much for the products in its stores and too much in rent to have the use of stores it no longer wants to operate. In addition to providing some relief from debt generally, bankruptcy also allows the debtor to review its contracts and leases, determine which are good for the business and which are not, and essentially divest itself of the contracts and leases that are not good for the business. Divestiture takes the form of “rejection” of a contract under Section 365 of the Bankruptcy Code. Once a contract is rejected, the other party has a claim for damages that is treated as if it arose before the bankruptcy case was filed. If the debtor wants to continue with the contract, it is “assumed,” or instead “assumed” and then assigned to someone else (usually a purchaser of assets from the debtor who wants the benefit of the contract along with the assets). If a contract is assumed, the debtor/assignee must cure all defaults under the contract and provide “adequate assurance of future performance” (that is, not provide immediate and glaring evidence of inability to pay or perform).

In order for a contract to be subject to assumption or rejection, some performance must be due on each side or, in bankruptcy language, the contract must be “executory.” Although the Bankruptcy Code provides a list of definitions for various terms it employs, somewhat surprisingly, “executory contract” is not among them. Nevertheless, the definition I have provided is uniformly accepted by the courts and disputes regarding whether a contract is executory or not arise in connection with how much, or how little, performance is required to keep a contract “executory.” The answer is: not much. Even a license agreement, under which the licensor is allowing the licensee use of a trademark – for example “Motel 6” – is executory because the licensor must maintain and defend the trademark. Thus, if you have a contract with a debtor that obligates you to do anything at all, you should at least assume that it will end up being executory. Contracts to lend money or to extend financial obligations are not, however, executory, no matter how much they may look like they are. Why? Because the Bankruptcy Code says so in Section 365(c)(2).

Now, of course, bankruptcy cases, even if planned, often have to be planned in a hurry, and a debtor will need time after the filing to figure out what it wants to do, what its creditors will allow it to do, and what the court will determine is appropriate under the circumstances of the case. What happens to executory contracts while the debtor is trying to figure out which ones to assume or reject? Suppose the debtor requires performance under an executory contract in order for its business to survive? For example, take the case of a bankrupt airline to which you supply fuel to keep the planes in the air. The debtor might want to see if it can get a better deal on aviation fuel before it decides what to do with your contract, but, in the interim, it needs the fuel. Suppose the debtor owes you $2,000,000 for fuel supplied before the bankruptcy was filed: may the debtor force you to supply fuel under the terms of the contract, including credit terms, before it decides whether to assume or reject your contract?

Most bankruptcy courts answer ”yes” to this question, on the general theory that this result “preserves” the contract for assumption or rejection and provides the debtor with the necessary time to make intelligent decisions about its executory contracts. “[A] debtor-in possession’s ability to continue to perform and to compel performance with respect to assumable executory contracts is usually the life blood of its reorganization,” says the United States Bankruptcy Court for the Southern District of New York. In re McLean Industries, Inc., 96 B.R. 440, 449 (Bankr. SDNY 1989). (In a liquidation case under Chapter 7 of the Bankruptcy Code, early rejection of executory contracts is compelled, because there is no business to reorganize.)

You will notice that I said that “most courts” agree with the SDNY – most, but not all. If you happen to be involved in a bankruptcy case in the Western District of Michigan, which includes Grand Rapids, headquarters of Amway and birthplace of President Gerald Ford, you will find that the matter of executory contracts is handled differently. First, one starts with the proposition that what comes into bankruptcy is not magically transformed by its transit from ordinary business life into a bankruptcy estate. Second, under general principles of contract law, if the other party is in material default under your contract, you have no obligation to continue performing until the default is cured. Restatement, Second, of Contracts, Sections 225, 242.   Therefore, a debtor that is material default under your contract cannot force you to perform until the contract is assumed and the default cured. In re Lucre, Inc., 339 B.R. 648 (W.D. Mich. 2006) (yes, the debtor company in this case was called Lucre, Inc. – as Nietzsche said, we have art to protect us from the truth).

So, which approach is correct? Lawyers will often answer this question by identifying the client they represent. Or, one can say that, unlike science, in law, you begin with the answer and work your way back to the question.   Nevertheless, it is important to realize that, in the absence of a Sanity Clause, all we have are the analytical and logical tools that the law provides, which are often more extensive than we might think. Those tools, properly employed, often lead to just results, or, at a minimum, results that we can understand, if not endorse. Therefore, the next time you hear the words “executory” and “contract” applied to any contract to which your business is a party, have your bankruptcy lawyer on speed dial.